We’re spending a few weeks helping families of college students figure out how to pay the bills for the upcoming semester (and beyond), and hopefully offering some smart money moves to make during this very important (and stressful) time.
This week we’ll tell you how to balance paying for higher education expenses with savings, debt, and income.
Families who are fortunate enough to have accumulated some money for college understandably prefer to exhaust their savings and investments before taking out any loans.
But it may be safer for parents and students to use any loan proceeds first, and keep the saved money for education expenses that are incurred during the last few years of school—especially if the borrowers can obtain low-interest federal or private loans.
Yes, there may be some initial fees and ongoing interest expenses on the loans. But in the near future student and parent loans may be more difficult to get than they are today, and may have even higher fees and interest rates.
Or the family or student may incur a more immediate financial emergency (such as a parent’s job loss), and need to tap the college savings accounts to pay for living expenses.
If neither of these negative scenarios occurs, the savings can be used to pay for the last few years of college, and/or pay off the education loans.
Once it’s time to tap savings and investments to pay for higher education expenses, there is generally an order in which the accounts should be liquidated, and it could end up increasing the overall financial aid awarded and reducing potential taxation.
Start by spending any money saved in accounts registered in the student’s name, and that use the student’s Social Security number (i.e. “UTMA/UGMA” accounts).
Once those are exhausted, move on to 529 college savings accounts (such as Wisconsin’s EdVest account), since withdrawals from these are only tax-free if used for qualifying higher education accounts.
Then move on to any non-retirement savings and investment accounts owned by the parents.
If you still need more money to pay for higher education expenses and have to tap retirement accounts, look first towards your Roth IRAs.
The contribution portion of Roth IRAs can be withdrawn at any time, for any reason, with no taxes or penalties whatsoever.
IRAs and 401ks should only be used to pay for college costs as a last resort, but two advantages of using these accounts should be considered.
First, IRA distributions used to pay for higher education expenses may avoid the 10% penalty for distributions normally applied if the owner is under age 59 ½. However, the distributions will still be taxed as ordinary income.
If possible, instead of making a withdrawal from the 401k to pay for college, it may be better to borrow from the account. However, that entails a separate set of potential costs and risks that we’ll address next time.
Using income intelligently
Of course, parents and students may choose to pay for some uncovered college costs the old fashioned way: from their paychecks. But it’s not always best to prioritize tuition dollars first.
Parents are probably better using any earnings to first pay down high-interest debt (like credit cards), and obtaining lower-interest (and potentially tax-deductible) education loans to pay for higher education expenses.
Some moms and dads may want to stop saving for retirement and instead redirect that money towards college costs. That makes sense, but they should at least save enough to get any employer matching contribution made to at-work retirement plans.
Students should weigh the income they get from a job against the time and energy they will spend working, especially if it takes a toll on the quantity and quality of their education.
They may instead be better off borrowing what they could otherwise have earned, and then taking a heavier class load and getting a degree sooner (and perhaps with better grades).